How-To Series: Start Profiting with Options in Two Easy Steps
Rookie investors and experienced pros alike can miss some serious gains because they’re not trading options.
Options are a versatile, easy-to-use, indispensable tool for investors. Here’s why…
With options, you can bring in regular monthly income payments with little downside risk – perfect for retirees.
But you can also play for triple- and quadruple-digit gains in less than a week.
Trading allows investors to use leverage to control huge positions in some of the biggest, most valuable companies on the planet for pennies on the dollar.
But plenty of investors never see this money, because Wall Street has made the simple process of getting started intimidating. It simply doesn’t want regular investors to get in on these trades. And why would it? It collects fatter fees that way.
How to “Rent a Stock” and Double Your Money
I first got involved with stock options back in the 1990s the way a lot of people do.
I was given some by my company as a perk called an ISO, an “Incentive Stock Option.” What I didn’t know then was that anyone could buy and sell these types of options on the exchange without being a key employee of a company.
And this is the first piece of education you should be getting when it comes to options:
Once you get comfortable with the basics, the opportunities to make money become endless.
Options are one of the most versatile, if not the most versatile, trading instrument ever invented. Since options cost less than stock, they provide a high-leverage approach to trading that can significantly limit the overall risk of a trade or provide additional income.
To me, an option is like renting a stock, with the intent to turn around and “sell the rental” to someone else when the stock moves in the direction you want.
I love buying options under the right conditions. Call option buyers have the right, but not the obligation, to buy the underlying stock at a specified price until a specified time (its expiration).
It is essential to become familiar with the inner workings of calls before moving on to anything else. Everything you learn from this point on depends on your thorough understanding of this basic call strategy.
Today, it’s actually very easy to get started trading options. For one thing, it’s 2018 – not the 1990s, when trades could only be done over the phone, approval time took weeks, and commissions were sky-high.
A lot has changed. Technology – and fierce competition for your investing dollar – means approvals can take just minutes, trades on liquid options can be completed instantaneously, and commissions are still sinking fast.
That makes this the perfect time to get started. It really is incredibly easy…
Call Options in Action: Low Cost, Low Risk, High Reward
Oneok Partners LP (NYSE: OKS) is an oil stock that’s engaged in the gathering, processing, storage, and transportation of natural gas in the United States. When I first approached this trade idea, my charts were showing that OKS was languishing just a bit at around $40 and was trading well below its 50-day Simple Moving Average (SMA).
As part of the strategy to take advantage of OKS’s position, I used my “Money Calendar” to spot a buying opportunity. The Money Calendar is my proprietary tool for looking at undervalued companies that have pulled back and are ready to explode upwards.
Typically these types of signals are good for about 30 days. Look at the chart below and you can see that this upside target price coincided with the 50-day SMA.
All OKS had to do was test that moving average and a double would be possible.
Should it move as my proprietary tools showed it could, a double on a low-priced option with a move required from the stock could be in order.
Now in order for this stock to double, I was looking at an $80 price target. That would mean oil would need to get to $100 a barrel in 30 days… which was not going to happen.
But a carefully chosen option could do it on a small stock move…
The following example shows just how rewarding call options can be…
Remember when I talked about calls, and how they are cheaper than stocks? To own 100 shares of OKS at that time, you would’ve needed about $4,000, plus commissions.
But call options allowed me to “rent” the stock for $110 ($1.10 x 100 shares). That’s less than 3% of the cost of ownership! And by the way, I only planned on renting this stock for a maximum of 30 days.
What’s the total risk on this trade? Well, in this case study, it’s $110, plus commissions. That means the worst that could happen is OKS drops, and I am out $110 per contract.
Let’s imagine for a moment that OKS dropped in half over the next 30 days. A stock trader buying 100 shares at $40 would see a loss of $2,000, while the “renter” would lose no more than $110.
Meanwhile, the reward on buying a call option is unlimited until its expiration. Unlimited is a vague term, so let’s put it in the perspective of this trade.
My “Percent to Double” tool tells me that I only need a 6.84% move on OKS to theoretically double my option value. The target price I needed the stock to hit was $42.15.
How to Master the Basics of Call Options
If XYZ Corporation is trading at $100 a share, it would cost $10,000 to purchase 100 shares of stock. However, if the XYZ Corporation 100 calls are trading for 2 points ($2), you would need only $200 to purchase these options and “rent the stock.”
Here are some key terms you’ll need to know as you start your stock “rental” program:
STRIKE PRICE – The price at which an underlying stock can be purchased or sold if the option is exercised.
EXPIRATION – The date the option expires. Most stock options expire on the third Friday of every month, but about 250 or so have expirations that are every week.
PREMIUM – The price of an option. An option’s premium is determined by a number of factors, including the type of option, the current price of the underlying asset, the strike price of the option, the time remaining until expiration, and volatility.
An option premium is priced on a per-share basis. So that means if XYZ Corporation option is priced at $2, the total premium for that option would be $200 (2 x 100 = $200).
Within three weeks, OKS moved up to our target, and these options did double in value. So we saw a 100% return on renting this stock in a matter of weeks!
All with lower cost, lower risk, and a small movement on the underlying stock.
OKS is a relatively inexpensive stock. But this strategy also works with the biggest, priciest stocks on the market.
For example, last June, I was interested in a trade opportunity on Amazon.com Inc. (Nasdaq: AMZN). At the time, this stock was trading right around $429.92. So if you wanted to buy just one share, you’d need to fork out almost $500.
And forget buying 100 shares of AMZN for any less than $42,992…
But without ever buying a single share of stock, I was able to control 100 shares of AMZN for just $390.
And based on a 10-year historical pattern for AMZN, I only needed the stock price to make an upward three-point move in order to make 100% gains.
But this trade did even better – netting gains of 122% in just 11 days.
Now that you understand how options work, here’s a “Quick-Start Guide” that walks you through opening up an options account, step by step…
Step No. 1: Make Sure Your Brokerage and Platform Are Options-Focused
Many people seeking to trade options already have a stock brokerage account. Before you place a call to your broker or go online to start the process of opening an options account, make sure you want to trade options through your brokerage firm.
There are stock firms that offer options trading, and then there are options firms that offer stock trading.
We like options firms, because they know what options traders need…They haven’t just programmed an options platform on the side of their equity trading to cover all their bases.
If You Need a Brokerage
Option firms build their platforms from the ground up, in many cases offering easier and more streamlined platforms in which to trade. Commissions are generally lower as well, as they are looking for active traders – they want your business.
Now, all options trading platforms are not created equal. You definitely want to make sure your platform offers “spread” trades, too, because these trades can be a great way to hedge your risk and boost your profits – when you get further along in your trading, you’ll see why. If you are a new options trader or a position trader – meaning you hold trades for periods of longer than 30 days – then it might make sense to use a web-based platform rather than a streaming one.
Web-based platforms such as that used by OptionsXpress (screenshot to the right) are great for someone just getting started. They are easy to master – from simple option purchases even up to three- and four-legged spreads. And the platform is set up nicely in a step-by-step format when it comes to placing an order.
The disadvantage with platforms such as this one, though, is that they offer more of a snapshot of the market, rather than a constantly streaming window into trading activity.
The chart below comes from “ThinkorSwim,” TD Ameritrade’s active platform. Now, this one has all the bells and whistles. It allows you to chart and analyze stocks in real time. It also allows you to set up real-time scans and indicators, with alerts to let you know if a bullish or bearish trade signal is present.
All of these bells and whistles can have their drawbacks. Entering orders on a real-time platform can at times be a bit daunting with everything that’s happening on the screen.
Whether you decide to go easy (web-based) or go crazy (computer-based) should depend on your experience level and how smoothly you manage through computer screens. If you are a computer novice, a web-based platform should suffice.
If you are more computer savvy, then perhaps an active trader platform is for you. If you are not sure, you should start with a web-based platform and graduate to an active trader platform when you feel ready.
Key Points for Call Option Trading
Step No. 2: Breezing Through “the Questions”
Opening an options account can feel a bit like an inquisition. There are a lot of questions that seem to be getting at the same thing… liability and risk. The way you answer these will determine:
Whether you get authorization to trade options.
What level of options trading authority you qualify for.
Each broker’s trading authorization form is different, but they typically have the following types of questions:
Investment Objectives – The choices here will range from “income” on the low side to “speculation” on the risky side. Even if you plan to do the most trading in low-risk covered calls for income, if you want to make the occasional play for bigger gains (at a greater risk), you’ll probably want to apply for “speculation” so you won’t run into a stumbling block when those big-gain opportunities appear.
Options Strategies – These questions seek to discover what type of strategies you are familiar with. The more that you understand, the higher trading level you will qualify for. Keep reading up on Daily Trade Alliance to learn about the majority of these strategies.
Trading Strategies – There are several questions that will come up here, and the biggest takeaway at this point is that the more strategies you select, the higher your chances of getting a high trading authorization.
Trading Experience – Again, like trading strategies, the higher a number here, the better. If you don’t have a lot of experience, think about the future of what you believe you will be trading, and factor that in.
Personal Finances – These questions will be straightforward and consist of your “liquid” net worth, total net worth, annual income, source of income, etc. Do right by yourself and be honest here, as this type of information is easily attainable and the firm could come back to you with questions if things don’t match up…
Your goal is to get that correspondence back saying you have option trading authority. Most option firms require a minimum deposit of $2,000 to $3,000, and to get started it generally takes only the time required to get your money cleared through the broker.
Now, once you are set up, sit back and enjoy the moment…
You are about to embark on a journey that is very rewarding for those who get it right. Keep reading Daily Trade Alliance for more guidance as you move forward.